Return Assumptions: It’s All Just Borrowing in Disguise

Saturday’s Wall Street Journal featured an article by David Reily highlighting that most state and local pension systems were sticking to “unrealistic” return assumptions. Most public pension systems assume their assets will return around 8% annually, and the lowest assumption among major public pension systems is 7%. According to the article, only a handful of funds have reduced their return assumptions, despite an environment where such returns seem unlikely. Lowering the assumption would require that more money be set aside today to fund legacy liabilities as well as ongoing pension promises — and in these times the governments don’t have the dollars to spare.

While lower return assumptions would be a step in the right direction, it is important to keep the big picture in mind. This entire system effectively treats the expected return on the pension fund assets as achievable without any risk. When a state assumes, say, 7% instead of 8%, it sets a little more money aside and does a little less gambling on behalf of future taxpayers (our kids and our elderly selves). But the scheme still amounts to making future taxpayers come up with money exactly in those conditions (or “states of the world” as finance academics like to say) when it is most painful — namely when the stock market and other risk-bearing investments have performed poorly. That’s a situation when the other financial resources of future taxpayers — our retirement and college savings accounts — are also diminished.

This situation should sound eerily familiar, because we are living it today. Cash strapped state and local governments have lost money in their pension funds at the same time as their tax revenues are down. The rules say they are supposed to be contributing more to pensions to make up for the new shortfalls. But this is exactly the time when there isn’t any extra money in the coffers. Did any risk managers think of that when they were setting the asset allocation for these funds? If systems just double down in hopes of making 8% returns in an even more unlikely environment, we’re going to repeat the same mistake.

When a state funds a pension at anything less than the risk-free rate, it is exploiting a loophole around the principle that states should run balanced budgets. With underfunded pensions invested in risky assets, the state has set things up so that future generations only have to pay back if the stock market performs poorly. Upon first hearing, that might sound better than just outright borrowing from the kids and our elderly selves, but in fact it is no better. The further the stock market falls, the more we all will have to pay up, and the more painful it is because the less money we have. Finance academics call this idea “state pricing,” where “state” refers to “state of the world” — and it is the core of all finance theory.

It is interesting that the National Association of State Retirement Administrators (NASRA), one of the sources for the WSJ article, is publicizing statistics not just on return assumptions but also on benefit changes. Just like benefit parameters, return assumptions are easier to raise in good times than they are to lower in bad times. Those who want to perpetuate a system of surreptitious borrowing from future taxpayers will be the ones who are most eager to point out the small incremental changes that could allow allow politicians to claim “problem solved” (or “mission accomplished”) when in fact they represent only a very small step forward.

In sum, systems that use 7% are being more responsible than those using 8% — but even 7% is a flagrant violation of the principle that states should run balanced budgets. Already this system has led to state pension debt that when properly measured amounts to $3 trillion across the 50 states, since unfunded pensions were the way that politicians could borrow money out of the view of taxpayers and outside of budgetary requirements.

If going forward we want to actually return to the principle that states should run balanced budgets, there are only two routes for future retirement benefits: 1.) defined benefit (DB) pensions funded at risk-free rates and invested in bonds that match the profile of benefit payouts; or 2.) 401(k)-type defined contribution (DC) pensions like the private sector. Anything else is simply borrowing in disguise.

It is funny now that Dr. Rauh’s flawed assumptions have been soundly (and roundly) deflated by rebuttals from supposedly failing retirement systems who are actually earning 8+ percent average returns for years, who have been consistently making payments on unfunded accrued liabilities for decades, and who have instituted solid system reforms including raised retirement ages and higher employee contribution rates, Dr. Rauh has now deflected the issue to the silly argument that assuming a rate of return higher than his artificial “risk-free” ROR is borrowing from the taxpayer. Dr. Rauh needs to review the principals of accounting, assuming he learned them in the first place.

Interesting remarks. I would argue that the practices of state and local pension funds violate fundamental principles of financial accounting — in addition to violating common sense.

Under generally accepted accounting practices, companies cannot write down their liabilities by increasing the amount of risk they take with their assets. Nor can they write down their liabilities by increasing the returns they assume on a given portfolio. But government pension systems can.

What about households? Households can’t write down their liabilities by increasing the amount of risk they take with their assets. Try going to a bank and arguing that your financial net worth is higher if your money is in stocks than in bonds. The bank wouldn’t accept your argument, but apparently GASB would.

So my question is why governments are allowed to operate in a framework that no private sector accountant would accept.

The state of SC (where I live) changed their investment strategy in 2007 ( a referendum vote giving the state the power to make risky investments). Before 2007 the pension funds were invested in safe fixed investments. Since then the new management company is investing a large portion of the funds in derivities, hedge funds, futures markets, overseas stocks and real estate. Not exactly a safe portfolio. At the same time they use 8% return when in fact the Dow over the last 10 years was barely over 2%. Not to mention that 3% of the funds are used to pay annual fees and expenses. The state retirees are guaranteed a 2% COL when they retire. 9 years ago pension benefits paid out were less than $200 million. In 2010 the payout was $819 million with basically the same number of retirees. At that rate SC will run out of money much sooner than your predictions. The SC Retirement System is reporting that the pension funds are sound and no changes need to be made. There is no way we can continue this folly.

[…] As for whether we take a “pessimistic angle,” we don’t see any of these assumptions as particularly bearish. One cannot assume that the pension funds will receive with certainty the same returns they earned in the past by betting on the stock market. The fact that most systems are attempting to target 8% returns in an environment where the 10-year bond is yielding 3.0% necessarily means that they are taking on even more substantial investment risk than in the past, exposing taxpayers to an even larger downside since the pensions have to be maintained regardless. (For more, see “Wipe Away Your Debts with State Government Accounting” and“Return Assumptions: It’s All Just Borrowing in Disguise”.) […]